THE TASK AHEAD: CREATION OF A
FREE ENTERPRISE SYSTEM AFTER A CENTURY OF STATE CONTROL

FROM THE BERLIN WALL TO THE
INVISIBLE WALL: "General
Secretary Gorbachev," President Reagan asked at the Berlin Wall, June 12,
1987, "if you seek peace, if you seek prosperity for the Soviet Union and
Eastern Europe, if you seek liberalization: Come here to this gate! Mr.
Gorbachev, open this gate! Mr. Gorbachev, tear down this wall!" The Berlin
Wall fell, but at the outset of the Clinton and Yeltsin administrations, an
invisible wall of high tax rates, limited market competition, weak contract
and property rights, and no real banking system confined Russians. Clinton
policy reinforced this invisible wall with bad economic advice that
contributed to Russia's economic collapse in 1998. Trade with the
Communist-controlled People's Republic of China was a higher priority than
trade with Russia. Tax collections were emphasized over rate cuts.
Government-to-government loans substituted for growth policy. Capital flight
undermined investment in Russia. Predictably, Russia's economic output
plunged 40%. Clinton policy contradicted advice from President Reagan in his
Berlin Wall speech: "In West Germany and here in Berlin," the President
said, "there took place an economic miracle, the Wirtschaftswunder.
Adenauer, Erhard, Reuter, and other leaders understood the practical
importance of liberty-that just as truth can flourish only when the
journalist is given freedom of speech, so prosperity can come about only
when the farmer and businessman enjoy economic freedom. The German leaders
reduced tariffs, expanded free trade, lowered taxes. From 1950 to 1960
alone, the standard of living in West Germany and Berlin doubled."AP Photo/J. Scott
Applewhite

For 72 years,
Communism in Russia waged a silent war against the human soul. Sometimes
screams were heard from torture chambers deep in prisons and in detention
centers, but mostly the war was fought with ideas and incessant public
propaganda ... Communism ... wounded the habits of honesty and trust,
self-reliance and fidelity to one's word ... The transition from Communism
to a free society is consequently a severely demanding moral task ... How
that transition goes is perhaps the greatest issue of our
time.

Michael Novak,
writing in
Commentary, June/July 2000

Economic
science adds that the more successfully private business is run in society
and the more (so to speak) whole coats there are, the firmer are its
foundations and the more the commonweal flourishes. Thus, while busy
acquiring only and exclusively for myself, I actually, at the same time as
it were, acquire for all and help bring about a condition in which my
neighbor receives something more than a torn coat. And he receives it not
from the private charity of a few but as a result of overall improvement.
The idea is a simple one. Unfortunately, it has been too long in reaching
us.

Fyodor Dostoyevsky,
Crime and
Punishment,
1866

Without
justice, what is the state but a band of thieves?

St. Augustine,
The City of
God

The English philosopher John Locke argued that the
essential function of government is to protect life, liberty, and property. The
Soviet Communist system--which killed at least 20 million Russians, denied
freedom of thought and expression, and confiscated property--turned Locke's
prescription upside down.1

The task facing the Russian people in January
1992 was to replace Communism with a free enterprise system and a democratic
government that would protect life, liberty, and property.

The collapse of Communism in Russia ended not
only the Soviet police state, the gulag, the one-party dictatorship, and the
monopoly of state-controlled media but also the Soviet centrally-planned
economy. The perestroika of the last Communist Party General Secretary,
Mikhail Gorbachev, had been an effort to refine, not to replace, the command
system of the Soviet Union. But now, in January 1992, there was for the first
time in the experience of most living Russians a genuine opportunity to build
the foundations of a free enterprise system.

The economic system in Russia at the dissolution
of the Soviet Union was fundamentally dysfunctional because the state attempted
to control far too many aspects of life. Whereas in Eastern Europe for some 45
years Communism had been superimposed on largely market economies, in Russia
Communism had been in place for the better part of a century, and had been
imposed on a society with comparatively little experience of free
markets.

Any small private farms that had existed before
Communism in Russia were brutally collectivized. In Stalin's phrase, the people
who owned the farms were "liquidated as a class"--and often as individuals. In
Poland, by contrast, small, privately-owned farms survived the post-World War II
imposition of Communism: by some estimates, 30% of the Polish economy was
privately controlled even during Communist rule.2 The seeds of free enterprise in Russia would be planted
on less fertile soil.

SMITH BURIES
MARX: Nina
Khrushcheva, the 32-year-old granddaughter of the late Soviet Premier and Cold
War leader Nikita Khrushchev, signs autographs with President Nixon's grandson,
Christopher Cox, for visitors July 28, 1996 at the Richard Nixon Library and
Birthplace in Yorba Linda, Calif. In the background is a photograph of
Khrushchev with Nixon. While her grandfather told Nixon "we will bury you," Nina
Khrushcheva noted that the challenge facing Russia at the outset of the Clinton
administration was that "there could not have been a culture more out of touch
with Adam Smith." AP Photo/Damian Dovarganes

According to Nina Khrushcheva, granddaughter of
Soviet dictator Nikita Khrushchev: "There could not have been a culture more out
of touch with Adam Smith."3 Acting prime
minister Yegor Gaidar put it this way: "[A]fter seven decades of a regime for
which private enterprise was not merely a dirty word but a criminal act...[t]he
hostility toward private property permeated all of Soviet legislation and law
enforcement."4

The Soviet economic bureaucracy in Moscow made
decisions for 270 million people inhabiting eleven time zones. Soviet planners
constructed an economy devoid of individual initiative and dominated by military
spending. Individuals in the Soviet Union who sought to earn a profit were
subject to imprisonment for the crime of "speculation." Central planning
affected all aspects of the individual's life.

To move from this vast state-controlled economy
to a free enterprise system based on private property, markets, and individual
choice called for change on a breathtakingly large scale.

For the government, there were three main
tasks:

* Soviet-era laws and regulations
governing commerce would have to be repealed--not just in Moscow, but in each
regional legislature.

* New legal protections for private
property and private contracts would have to be enacted.

* The courts would have to build public
confidence that privately-made contracts would be binding and
enforceable.

Critiques of the reform process in Russia have
often centered on a handful of generalities. Analysts of all ideologies decry
the lack of "transparency" in Russian regulation, the need for the government to
establish the "rule of law," and the need for the government to build efficient
"institutions." In testimony before the House International Relations Committee
in September 1998, then-Deputy Treasury Secretary Lawrence Summers repeated
these formulations. However, the economic challenge that faced Russia in 1992,
and continues today, is not simply to establish a better-working
government. It is to fundamentally shift the responsibility for economic
activity away from the government, and to individuals.

Transparency, the rule of law, and efficient
institutions indeed are all vital elements of a well functioning free enterprise
system. But they can also be consistent with statist economic systems, from
Communism to Fascism to Socialism. What distinguished the Russian predicament in
1992, and required remedial action above all else, was that private economic
behavior and private property had for so long been illegal.

Russia's task would be to focus all its energies
on building the foundation for private initiative in place of government
involvement in the economy. These historic circumstances demanded that the
central government be cut down to size, and private enterprise legalized and
encouraged.

From Gosplan to
Supply and Demand

Before Russia could
prosper, the complex Soviet system, a portion of which is reflected in the chart
above, had to be replaced with the elegantly simple market system of supply and
demand, depicted below in a graph familiar to all students of introductory
economics. Russians eliminated the Soviet planning bureaucracy, which included
50,000 territorial administrative units, but other prerequisites to prosperity,
including competition, enforceable contract and property rights, and efficient
debt and equity markets, were delayed. "Privatizing" Russian assets before the
creation of a market economy, rather than after, left individuals and firms
unable to transmit accurate supply and demand messages to each other, which in
turn caused economic contraction instead of growth. Soviet planning chart
courtesy of Congressional Research Service

Tearing Down the Soviet
Network

The Russian economy was divided into about
200,000 state-owned enterprises. Of these organizations, about 600 gigantic
industries were responsible for 47% of the Soviet Union's non-military
industrial production.5

For most of these industries, competition was
non-existent: they enjoyed a state-enforced monopoly in particular markets. The
management of these firms was uninvolved in the strategic decisions normally
made by a company's executives. Instead, central planners in Moscow determined
quantity and quality, chose suppliers and distributors, and decided what markets
were open to industry. This reduced management to little more than production
foremen.

During the final months of the Soviet Union,
control over enterprises had in some cases been partially devolved to
governments in the republics, complicating the prospects for privatization by
giving multiple and competing levels of government claims on controlling the
privatization of particular industries. In many cases, the resulting limbo left
local plant managers and workers in control of factories regardless of the
nominal ownership.

The inertia of 70 years of central planning kept
producer-supplier relationships in place, despite the collapse of
government-organized payment arrangements.

The "privatizations" of the 1990s would later
fail to disintegrate the network of inefficient supplier relationships
established under the Soviet command economy. This was true in part because the
management remained the same, but just as importantly, because the
incentives to change were missing.

Thus, the Soviet enterprise network continued to
operate in essentially the same manner even after the fall of the Soviet Union.
Products were still produced in qualities and quantities unrelated to market
realities. And while a market economy would have quickly bankrupted inefficient
companies that consistently lost money, in Russia these companies continued to
limp along, often through continued state subsidies.

The European Bank for Reconstruction and
Development later reassessed the first years of economic reform in Russia and
Eastern Europe, concluding: "The consequences of the privatization strategy
adopted in Russia have been highly adverse for the governance of enterprises and
the allocation of resources, not least because of the clear failure to break the
political constraints on restructuring and company closures."6

"Privatization" is impossible without a
functioning market economy into which formerly state-owned assets can be sold.
Nonetheless, throughout the 1990s both Russian policy makers and their American
advisors (who should have known better) rarely concerned themselves with doing
the government's part to establish a market economy. In a free enterprise
system, government referees the game, but it is not a player. In the Russian
"privatization" scheme, the government relinquished only some of its rights to
play the game, and it continued to call too many--and sometimes all--of the
plays. As a result, the "privatized" Russian enterprises lacked the normal
incentives that cause the efficient allocation of resources in free
markets.

Without enforceable property rights, the
proprietors of "privatized" firms lacked the incentive to run companies
efficiently and in accord with economic reality. Instead, producing profits for
the firm's owners often required flatly illegal conduct. The government's
continued subsidies for industry only encouraged such conduct, by providing
opportunities for owners to strip away assets for their own personal profit,
without market discipline.

The task in 1992 was to tear down the Soviet
enterprise networks and provide neutral, pro-competitive rules to permit
individuals to build new firms in an expanding market. "Privatization" without
genuine private property and authentic markets could not accomplish this
task.

Establishing Private
Property Rights in Land

In 1991, the Russian language did not even have
a word or term that captured the essence of private property in land,
underscoring how alien this notion was to the Soviet system. Property belonged
to everyone, and therefore to no one. As a result, incentives to maintain and
enhance the value of real property were absent in Soviet-era society.

The lack of any legal, cultural, or customary
basis for private property in land in the Soviet system stifled initiative,
suppressed entrepreneurship, wasted valuable human and physical capital, and
contributed significantly to the ultimate collapse of the Soviet Communist
regime.

In 1991, the Soviet state owned an estimated 1.5
trillion acres of arable land. Breaking the state monopoly over real property
was an important first step to allow Russians to use it to generate real wealth.
Beyond de-collectivization of the massive state farms and the "privatization" of
state-owned industry and housing, a means was required to distribute land to
Russian citizens who for decades had been deprived of the opportunity to own
it.

The enormous task of moving vast acreages of
Russian land from state control to private ownership was not unprecedented. The
United States faced a similar challenge in the 19th century. By the 1850s,
America's huge land acquisitions had left the government in control of over half
of the continental United States. Transferring government-owned land west of the
Mississippi River to private ownership became an enormous--and
urgent--project.

In 1862, President Abraham Lincoln signed the
Homestead Act, one of history's most notable examples of establishing private
ownership from scratch. The Homestead Act allowed each citizen to claim
one-quarter square mile of surveyed government land for his home, as long as he
improved it with a dwelling and grew crops. If the owner maintained the property
for five years, permanently clear title was issued.

The Homestead Act and subsequent laws succeeded
in transferring vast portions of the United States from government control to
private individuals in less than 20 years. Settlers first built homes of sod,
which were soon replaced by frame and brick houses. The private property owners
invested in trees to shield their dwellings, windmills to pump water from
underground, and a host of technologies that made farming profitable. This
remarkable transformation of prairie to developed real property was only
possible through the establishment of a key element of the free enterprise
system: individual ownership of land.

With such vast portions of the Russian
Federation under state control, Russia required legislation that would do for it
what the Homestead Act did for America almost 150 years ago--not only for
residential and agricultural land, but for real property that might be put to
any use.

Even more basic prerequisites for establishing
private property rights in land were accurate surveying as the basis for
certainty of title and public registration of ownership, so that others know who
owns what. For property ownership to be useful to individual Russians, titles
would have to be open to public inspection and well settled, with no "hidden"
state or private claims or rights against the property.

A registry of deeds traditionally serves this
function, although in today's global economy it is easy to imagine that a
private registry on the Internet or some other form of up-to-date database could
just as reliably catalogue real property ownership. The only essential is that
title be unshakable, readily transferable, and useful as collateral for loans.
Any number of public or private solutions would suffice, so long as the process
was precisely accurate and trustworthy.

The owner of land must be able to sell his
property on his own, without seeking anyone else's permission--including that of
the government. The owner of real property must also be able to use it as
security or collateral to borrow money. That, in turn, requires that the lender
have a speedy, legally reliable, and inexpensive way to acquire ownership of the
property if the borrower defaults. To this end, Russia's regional governments
would need to enact laws clearly defining every one of these aspects of
ownership.

Finally, because "rights" in land are useful
only if they are enforceable, Russia would need to establish a court system that
could be trusted to enforce protections for private property owners simply and
cheaply.

Establishing private property rights in land was
one of the most important elements of building a free enterprise economy in
place of Communism that Russia needed to undertake in 1992. By doing this, the
destructive linkages to the remnants of the Soviet system could be cleared away,
and the vast potential wealth in Russian land could be opened up as a source of
start-up capital for individual enterprise.

Establishing Private
Property Rights in Housing

Converting the existing stock of Soviet-era
state-owned housing to private ownership, and legalizing the construction of
more and better housing, was likewise an essential first step to build a
successful free enterprise economy. The housing shortage in Russia in 1992 was
symptomatic of the inherent problems of the Soviet system, including
restrictions on business and individual ownership of residential real
property.

The pseudo-privatization of Russian apartments
illustrates the difficulty that both the Soviet and Russian political systems
had in recognizing basic ownership rights. Just before the end of the Soviet
Union in 1991, Russia had allowed some of its citizens to "own" their apartments
at little to no cost. (By the end of 1993, 90% of Moscow residential property
was theoretically "privatized" in this way.) But such "private ownership" was
illusory.

Buying and selling apartment units was legally
and economically difficult or impossible. Soviet-controlled rents--frozen since
1928--covered less than 5% of the operation costs. It was therefore impossible
for "owners" to pay for property improvements.

The problem was exacerbated when the government,
which remained the landlord for "privatized" housing, stopped paying for
maintenance for newly-privatized apartments. Because their occupants did not
truly "own" them (in the sense that an investment in improvements could
translate to an increase in the owner's wealth), the apartments quickly fell
into disrepair.7

Nor had the government nominally gotten out of
the ownership picture; in fact, it had devolved the housing assets and
responsibilities to municipalities as a way of relieving itself of the burdens
of managing the apartments.8

The underdeveloped legal system that existed in
1992, with multiple overlapping jurisdictions and poor enforcement, was yet
another contributor to the lack of a housing market in Russia.

Not only were the Russian Federation's property
laws--the legacy of Soviet Communist ideology--hopelessly restrictive and
confusing, but also the courts were unwilling or unable to resolve the
conflicting mandates from federal, regional, and local authorities. A "war of
laws" began as various levels of government passed conflicting
mandates.

Nor was there any mechanism for resolving such
conflicts.9 Statutory contradictions were
left for individuals to resolve, with no recourse to any impartial
interpretation of a person's rights or responsibilities under the law. Thus, the
profitable use of residential real property was subject to arbitrary
restriction, with little or no protection from the government.

In addition to the need for genuine
privatization of housing, Russia needed private banks that would create a market
in mortgages. In order for ordinary Russians to afford to buy an asset as
expensive as a home, a convenient payment system over many years would be
needed. The requirement was for a marketable mortgage with a term of 20 to 30
years at a reasonable interest rate.

In 1992, Russia had none of these things, and
thus enjoyed none of the benefits of a free market. Little new housing was being
created nor old housing sold. No new wealth was created in real estate. The
absence of unassailable land titles, the absence of mortgage finance, the lack
of unfettered rights to set prices for rents and for property itself--coupled
with continued restrictions on the right to alienate real property--amounted to
no free market at all.

The lack of a viable mortgage lending system had
consequences well beyond a lack of adequate housing: it deprived Russians of
their most likely means of generating start-up capital for new enterprises. The
only significant tangible asset potentially available to the average Russian was
the home he or she occupied (and perhaps nominally owned). Mortgage finance
could turn that home from merely a maintenance cost into an asset useful for
generating wealth--an asset that has been the stepping-stone to the American
Dream for generations of Americans working their way into the middle
class.

If a competitive home mortgage industry were at
work in Russia, first thousands, and eventually millions, of Russians could use
their homes as collateral for small-business loans, creating the entrepreneurial
competition needed to break up the Soviet enterprise network. Lacking this
normal vehicle for supporting the nascent entrepreneurial class, however, the
most entrepreneurial Russians were increasingly being forced to turn to illicit
means to fund new businesses. The rest just didn't start businesses at
all.

As much as any other factor, the inability of
ordinary Russians to use their homes as a means to build businesses has slowed
the creation of a broad middle class in Russia, and the realization of the
economic and political benefits that it would bring.

The British magazine The Economist summed
up the challenge for the development of competitive markets in Russian housing
and mortgage finance:

This well described the situation in 1992.
Sadly, however, The Economist diagnosis was made eight years later in
2000. Nothing had changed.

Making Contracts
Enforceable

Yet another basic building block of a free
enterprise economy is the freedom to make private contracts, coupled with an
effective mechanism for their enforcement. In 1992, Russians had
neither.

Because Soviet enterprises were fully
government-owned, the need for a fast, efficient, inexpensive, and fair system
of resolving commercial disputes between private individuals and firms had never
been recognized in the Soviet Union. Contracts between state-owned enterprises
were relatively easily enforced: once a dispute was resolved by the appropriate
government entity, the loser had little choice but to accept the judgment and
act accordingly.

In most cases, moreover, the contracts
themselves were dictated from higher levels--so neither party was in a position
to question them.11

In 1992, recognizing that a sturdy and reliable
system of dispute resolution would be required to handle commercial
disagreements between private parties, Russia enacted an arbitration code and
established local arbitration tribunals throughout the country.12 But this was not nearly enough: most Russian courts had
no experience with arbitration awards, and they were often uncertain of the
procedures required.

As a result, while the new law endeavored to
legitimize private contracts, it failed in practice to guarantee truly useful
contract rights.

Even when a court or arbitration panel could be
made to stand behind a contract, the court's judgment was usually very difficult
to collect. According to American analysts writing at the time, "the process of
identifying, seizing, and converting the assets of the Russian party [against
whom a contract judgment was rendered] to cash ... [was] likely to be tedious,
time-consuming, and expensive."13

Moreover, without clear-cut property rights in
land, buildings, and housing, few Russians owned any marketable assets that
could provide the basis for enforcing a judgment in a private
dispute.14

Russian firms attempting to operate in this
environment in 1992 coped with the challenges through a variety of means,
including "blacklists" of unreliable suppliers,15 penalties imposed by Russian membership
organizations,16 and the use of organized
crime groups as bill collectors and contract enforcers.17 These options were not readily available to foreign
firms, however, with the result that the lack of enforceable contract rights
served as a significant impediment to foreign investment in the Russian
economy.18

Private Commercial
Banking

Just as clearly defined property rights are
essential to creating assets of real value, establishment of a private,
competitive, legitimate, accessible, and reasonably-priced retail commercial
banking system is vital to creating entrepreneurial opportunities.

Without private commercial lending, neither
startups nor expansions of businesses could occur. And without the competition
of new businesses, the Russian economy would forever remain captive to the
network of formerly state-owned enterprises.

The banking system that Russia inherited from
the Soviet Union performed none of the normal functions assigned to banks in the
West. Instead of accepting deposits and using those deposits to make loans,
Soviet banks acted as the financial arm of the government and of Gosbank, the
Soviet Central Bank.19

Rather than make loans based on objective
analysis of creditworthiness, Gosbank distributed and reallocated resources to
favored individuals, companies, groups, and industries at the direction of the
state.20 The Soviet government also used
Gosbank as a means to enforce quotas and production requirements, and its bank
balances were a prime means for Moscow's economic planners to determine if their
targets had been met.

Ending this role for the central government and
enacting sturdy, understandable, and pro-competitive banking rules was thus of
utmost importance in 1992.

Foremost in establishing a pro-competitive
banking system is that banks must be able to maintain an arms-length
relationship with industry. This is necessary to allow individual banks the
ability to concentrate on the normal banking business of risk analysis, rather
than on the implementation of government-dictated economic policies, the
subsidization of favored individuals or organizations, or the management of
industrial conglomerates. It is also important to avoid the perception of
insider dealings between the banks and the companies.

In the Russia of 1992, there was ample evidence
that no such arms-length relationship existed, and that neither the banks nor
the government could be counted upon to obey or neutrally enforce transparent
rules. In 1991, the Russian Supreme Soviet had passed a law mandating that
savings accounts be indexed for inflation if prices were liberalized. However,
when prices were decontrolled in January 1992, the law was ignored with impunity
by the state-owned banks then operating in Russia. Over the next several months,
99% of the savings of the Russian population were lost.

Yet another challenge for Russia was to
establish transparent accounting standards as a means of building public
confidence in the banking sector.

For private commercial banks to begin the normal
business of banking--that is, accepting deposits and making loans--the bankers
themselves would have to be assured that they could make loans with the
assumption of only a reasonable risk. For this reason, too, Russia needed to
establish real property rights in law, honest and efficient courts, and legally
useful means to enforce court judgments, so that bankers could use land and
buildings as valuable collateral.

Finally, Russia would need to convert its
Central Bank into an independent entity charged with setting monetary policy
independent of political needs. This would establish confidence among the
Russian public and foreign investors that they would be protected against
capricious changes in the value of their currency, and from official corruption,
thus encouraging deposits in the banking system and discouraging capital flight
from Russia.

Repeal of Soviet-Era
Regulations

The regulatory structure in the Soviet Union was
omnipresent, allowing little deviation from state-determined norms. In 1992 the
new Russian government inherited this panoply of regulations, and one of its
first challenges was to repeal them. So long as Soviet-era regulations remained
in place, there could be no free enterprise in Russia.

The regulatory regime that Russia inherited from
the Soviet Union was nowhere more pronounced than in the control of prices--the
primary mechanism by which Soviet planners had attempted to control all other
aspects of production.

Government-administered pricing hurt both the
quality and quantity of products. Prices were often so artificially low that
firms faced a choice between producing inferior goods, to keep costs in line
with the low prices, or producing goods of passable quality in quantities
insufficient to meet public demand. In other cases, by arbitrarily setting
prices too high for consumers, the government intentionally (or sometimes
accidentally) decreased consumption.

Decontrolling prices was necessary to permit the
economy to produce the high-quality goods and services the Russian people
needed. Just as important, price liberalization would have to be
across-the-board to avoid further disrupting the market.

As if to illustrate the latter point, partial
price liberalization was undertaken in 1992. It injured and confused the public,
for example, by creating anomalies where the prices of some goods that had not
been decontrolled rose in spite of government restrictions. Meanwhile, prices
for some other goods that had been decontrolled remained stable, due to pricing
by the market, while other decontrolled items soared in price.21

A series of export restrictions that limited
firms' access to international markets further undercut the potential
competitiveness of Russian firms. These regulatory impediments to reaching
overseas customer markets made stripping a firm's assets more profitable than
using them productively.

Regulations also forced the repatriation of
export earnings, discouraging companies with export potential from fully
reporting their earnings.

The regulatory regime that Russia had inherited
from the Soviet Union was keeping the economy stagnant, and reinforced the
predominance of the existing Soviet-era industrial and agricultural
enterprises.22 Dismantling this supporting
structure of regulations, which inhibited existing companies and limited the
entry of new firms in established markets, was an important first step in
dismantling the Soviet enterprise network.

Freedom to
Fail

Implicit in a functioning market economy is the
ever-present possibility of failure: the obverse of reward is risk. In the
Soviet system, however, failure was impossible because state-owned companies
were not allowed to go bankrupt. A never-ending stream of subsidies ensured that
no matter how poorly a company performed, or how useless were its manufactures
or services, operations would continue.

As newly-privatized firms were exposed for the
first time to the semblance of market conditions that was emerging in Russia in
1992, many began to realize that their business models, their method of
operations, or their products or services were wholly unsuited to the needs of
their customers. In a market economy, unsatisfied customers mean insufficient
revenues--and firms that do not adjust to meet customer demands quickly become
unable to pay their suppliers and workers. As a result, they go
bankrupt.

Bankruptcy in this sense does not mean that the
firms, their assets, their employees, or their products would disappear.
Instead, new management would be installed and the firm's operations could
continue, or the company's assets would be sold and deployed for more productive
purposes.23

In 1992, Russia was plagued with hundreds of
companies designed to function in a Soviet planned economy, and poorly equipped
to compete in a free enterprise system. Even when reincarnated as
newly-privatized companies, many continued to receive government subsidies to
keep their money-losing operations afloat.

So long as it failed to give such firms the
"freedom to fail," the Russian government would hurt the economy, and itself.
The economy was hurt because resources were consumed inefficiently, taxes were
kept high in order to pay the subsidies, and competition was stifled. The
government was hurt because low sales and no profit left little to
tax.

For all of these reasons, Yeltsin signed a
decree on bankruptcy on June 14, 1992. But the declaration had little impact.
First, it applied only to state-owned enterprises; bankruptcy of private and
newly-privatized enterprises was not addressed.24 Second, it prevented enterprises from being shut
down, and prevented large numbers of workers from being dismissed.25 Indeed, when the decree was superceded by bankruptcy
legislation in November 1992, it had not yet been used to shut down a single
firm.26

Nor did the 1992 bankruptcy law have more than
limited impact. Though the law established conditions for both voluntary and
mandatory bankruptcy proceedings, and directed the Russian government to
establish procedures to liquidate bankrupt enterprises, it was largely aimed at
preserving insolvent enterprises rather than eliminating them. Thus, one
government official argued that "the first task" of the new bankruptcy law "is
to help an enterprise survive."27

As of 1992, the lack of a workable bankruptcy
procedure denied Russians the freedom to fail, assuring that a large share of
Russia's productive potential would not be realized, and therefore also denying
Russians the freedom to succeed.

Reducing the Tax
Burden

Russia inherited Soviet tax laws that imposed a
crushing burden on individuals and firms trying to generate wealth. So-called
"windfall profit" taxes on enterprises reached as high as 90%, almost entirely
negating the incentives to build profit-making businesses.

For individuals, Soviet personal income taxes
were set at 13%, although the hard-pressed citizenry routinely ignored the
requirement with no consequences. In 1990, in an effort to raise revenue, the
Soviet Union raised the top income tax rate from 13% to 60% and imposed a new 5%
sales surtax.

On top of these taxes, the Soviet Union imposed
an additional tax on wages intended to dissuade employers from raising workers'
pay. The Communist central government feared that higher wages would fuel
inflation, because there were so few consumer goods available.

This high tax-rate regime left the system of
government finance Russia would inherit from the Soviet Union in shambles. Tax
evasion was rampant. International lenders--seeing no end in sight to the
country's economic woes--were reluctant to make new loans.

Even more destructively, as Russia took more
authority from the Soviet government in December 1991, the Russian Supreme
Soviet imposed a 28% value added tax on top of the taxes already in place--which
not surprisingly failed to increase government revenue.

Likewise, the Soviet bureaucracy of overlapping
and multiple tax authorities, which provoked widespread tax evasion, continued
in independent Russia.

Both the Soviet and Russian attempts to raise
tax revenue by squeezing the turnip did not and would not work. To the contrary,
lower tax rates were necessary to improve business conditions, reduce barriers
to entry for entrepreneurs, increase competition, and generate more business
earnings that could be subject to tax. Likewise, tax simplification was
necessary to discourage tax evasion.

Lowering the tax rate and simplifying the tax
code would demonstrate that the new Russian government was not bent on
redistributing income, as was the Soviet Union, but rather was serious about
discarding the Soviet system in favor of a market economy.

Prescribing the Rules of
the Road

Because private economic activity had been
illegal in the Soviet Union, there were few norms to guide private commercial
transactions. Therefore, the challenge faced by Russia's central and regional
governments was to promulgate a basic set of rules that could be relied upon by
any Russian citizen (or foreigner, for that matter) who wished to buy or sell
something.

While a system of clear, straightforward rules
for the conduct of private business was unknown in the post-Communist Russia of
1992, the free world had long since produced such rules.

The operation of commercial codes in the United
States is nearly invisible, but they are an essential part of a market economy.
Clear, understandable, and well-settled rules for such everyday events as sales
and leases of private property, business credit, bulk transfers, warehouse
receipts, bills of lading, and investment securities are the infrastructure of
the free enterprise system.

Today, neither Congress nor the legislature of
any state is much concerned with the pressing issues of 19th century commercial
law that gave rise to these codes. But that is not because these issues have
been overtaken by modern events; to the contrary, the old rules remain on the
books, in largely the same forms in which they first passed into the legal
mainstream. They work so well that we have mostly forgotten them. They are now
so well-established that a man or woman of commerce need give no more thought to
such a question as "at what point during shipment does title pass?" than to
breathing or walking.

The history of the United States' adoption of
its various state commercial codes also holds lessons for Russia. The United
States' experience was strongly influenced by our federal system, where both the
federal government and the individual states have the power to pass laws (and
where commercial arrangements are largely governed by state law).

In the 19th century, as the demands of
interstate business and individual movement throughout the country accelerated,
a unique solution to the problem of developing a nationwide commercial legal
infrastructure was achieved outside of government.

Neither the legislature of any state, nor the
Congress, but rather private individuals comprised a non-government body known
as the National Conference of Commissioners on Uniform State Laws. Formed in
1892 for promoting "uniformity in state laws on all subjects where uniformity is
deemed desirable and practicable," the Conference has since proposed more than
100 laws that have been adopted by at least one state.

The greatest success of the "uniform law"
approach in the United States has been in the field of commercial and business
law. The Commission's first product, the Uniform Negotiable Instruments Law, was
at one time in effect in all the states. Using this and the Uniform Sales Act
(also widely adopted) as a basis, the Conference (working together with another
private body, the American Law Institute) eventually produced the Uniform
Commercial Code. The Uniform Commercial Code is now in effect in some version in
nearly all U.S. jurisdictions.

The fundamental principle of the Uniform
Commercial Code is the empowerment of individuals to reach agreements among
themselves, without need of outside agencies of the state. Yet its greatest
importance lies in the specification of what terms apply if the parties to a
transaction don't mention something.

In the Russia of 1992, the lack of such clear
rules meant that a butcher in Moscow could not make a contract with a supplier
in Sergeiv Posad, an entrepreneur in Smolensk could not import fabric from
overseas, and a builder in Chelyabinsk could not obtain lumber from a mill in
Novosibirsk without incurring needless financial risk.

The overriding need for such rules in the Russia
of 1992 was to provide certainty and predictability to economic transactions--a
sharp contrast to the arbitrary dictates that had characterized the Soviet
command economy. Particularly because of its lack of a tradition of private
commercial activity, the enactment of a commercial code was a vital precondition
for Russia's transition to a functioning market.

Welcoming Foreign
Investment

Eliminating Soviet-era barriers to foreign
investment in Russia was yet another basic step needed to construct a free
enterprise system.

The climate for foreign investment that Russia
inherited from the Soviet Union was a fundamentally inhospitable one. Not only
were foreign investors deterred by the lack of market economy
essentials--enforceable private contracts, private property rights, an
established commercial code, competitive private banking, and a benign tax and
regulatory climate--but also foreign investors faced unique obstacles that
rendered any significant commitment to the Russian economy
unthinkable.

The laws limiting expatriation of earnings were
a unique burden on foreign firms seeking to invest in Russia. Capital controls
limited a foreign firm's ability to return earnings from Russia to their
stockholders. Further, government regulations discriminated against what
activities foreign firms could engage in, creating uneven competition between
foreign and domestic participants in the Russian market.

The Russian tax structure of 1992 likewise
discriminated against foreign investment and trade. Even today, the average
import tariff stands at 13%, the value-added tax on most imports is 20%, and the
excise tax on most imported luxury goods ranges from 20% to as high as 570%. On
top of that, Russia compounds various taxes
when it assesses import levies. Combined with non-tariff barriers such as import
licensing and customs processing fees, these taxes make the Russian market
especially unattractive to foreign investors.28 By keeping international trade out of Russia, these
Soviet-era regulations reinforced the economic arrangements existing at the
collapse of the Soviet Union. Instead of promoting competition that could serve
as a model and a spur to Russian entrepreneurs, Russian law served to insulate
the economy from these regenerating forces.

Tearing down these barriers to foreign
investment was thus another key task facing the new Russia of 1992.

Creating a
Market

The opportunities that awaited Russia in 1992
were exhilarating, but dismantling the Soviet system of government controls and
erecting in its place a free market economy based on private decision making and
risk-taking was a task of monumental proportions.

Yet the means to achieve the creation of a free
market economy were abundantly clear: the government's job was to get out of the
way of the economy, and facilitate private actors through the establishment of
enforceable private contract rights, private property rights, laws permitting
private commercial banking, commercial bankruptcy laws, a commercial code, a
much-moderated tax burden, and the repeal of Soviet-era regulations that
inhibited both domestic and foreign investment and trade.

These fundamentals of a free enterprise system
needed to be implemented quickly, or else "privatization" would be a sham:
"privatizing" assets into a non-market economy would represent merely the
continuation of the Soviet system, with the difference that the financial
benefits would now accrue to a few private individuals. It would lead to the
development of a kleptocracy masquerading as a free market economy.

What was needed was legality--the certainty that
private property rights will be protected--and the effective competition that
this would inevitably produce.